EMBA27## How to Determine a Company’s Profitability

You can evaluate a company’s profitability in several ways, including its profit margins, return on investment, and pretax income. It’s important for small-business owners to know how to measure profitability in these different ways, rather than just looking at their bottom-line monthly numbers. Looking at the different financial ratios of a company will help you get a better picture of its profitability.

To grow your business, you need to track financial information and measure performance. One metric you should be keeping an eye on is your business’s profit margin.

Look at Profit Margins

Some companies make their money on their volume of sales. Others make their profits on their margins. Both are examples of profit strategies.

Whether you sell a product or deliver a service, it is important to know your profit margin, which is the measure of profit you make, often calculated per unit. Profit margins are often the best profitability metrics to look at for a small business.

There are a few ways to look at your profit margin:

• Net profit margin
• Gross profit margin
• Operating profit margin

Return on Investment

Once you know your margins, you can look at the return on your investment. Let us say product A brings in a profit of ​$10,000​ per month, while your product B brings you an ​$8,000​ profit per month. Your product A makes you ​$2,000​ more in profits each month. You might think it’s better to invest more money into making and selling product A.

However, after you run your numbers to make and sell your products, you find that your product A is giving you a 12 percent return on your investment, while your product B is giving you a 28 percent return on your investment. You might decide, then, to invest more into making and selling Product B.

Pretax Income

Some small businesses do not want to make much of a profit. They want to reduce their corporate profits (and corporate taxes) by paying the owner and/or a few key investors or partners nice personal salaries.

Another way to look at a company’s profitability is to find its annual pretax income. This is your year-end profit after you have paid all of your expenses, but before you pay your taxes. Once you estimate or determine this number, you can look at tax strategies to reduce this profit. Companies do this to reduce their tax liability.

For example, if you have a year when you are going to make a big profit, you might decide to write off the entire cost of an asset. If you are not going to have a big profit that year, you can use that entire asset deduction by depreciating it over the course of several years. Or you can pay bonuses to key employees.

You can also reduce your taxes by using your year-end profits to buy new equipment, increase holiday season advertising or pay bonuses. If you’re a business owner, you can look at itemizing your business expenses, rather than taking the standard deduction.